China’s Multi-speed Economy: Opportunities and Challenges in Industrial Products and Services

Business leaders across China’s industrial landscape waved goodbye to a challenging and for many probably a worse than expected 2015. As we head into the Chinese New Year of the Monkey, the outlook for many players remains rather misty. The market is never to be predicted, but by analyzing past trends and events we can start to build a picture of the opportunities that lie ahead. In anticipation of the official release of China’s 13th five-year plan, we have summarized the key developments that shape the opportunities and challenges for industrial companies in China in the coming years.

GDP outlook: does it matter? Let’s start with the economic outlook. With 2015 growth hovering around 7%, the days of double digit growth are definitely over. Seven percent is the “new normal.” But is this really that bad? Yes, when you compare it against the 14% growth in 2007. But 7% growth equates to RMB5 trillion in incremental GDP in 2016, which is the same as the entire Chinese economy 20 years ago or the size of the entire Indonesian economy in 2014! In any major economy, 7% would be considered an economic miracle — in China, we call it a slowdown!

The headwinds that many industrial companies have been feeling in the past two to three years are not necessarily a market growth issue, nor will that be the case going forward. Growth of 6–7% per annum means the economy in 10 years will be twice its current size. In most cases underlying end-market growth across many industrial sectors will remain robust. However other factors are impacting company performance in the short term, such as overcapacity, cutthroat competition and the delay in capital spending caused by China’s anti-corruption drive.

China’s easy days of catch-up growth are over. Five years ago, all you had to do was be in the right place at the right time and you had a great business. The more critical issue for business leaders now is whether they have the right capabilities, business model and product offering to compete in this new normal environment.

China’s multispeed economy. Growth in China is not evenly distributed across the economy – China has become a multispeed economy. Some sectors are still showing very fast double-digit growth. For instance healthcare and environmental protection are doing very well and the digital space continues to explode. But other sectors such as the automotive space are slowing down to single digit growth.

So with average GDP growth around 7% and some parts of the economy growing much faster than that, by definition we are seeing some sectors that are flat or even in decline. Suppliers of capital equipment have been hit hard by a fall in demand due to overcapacity. Also the government is trying actively to rebalance the economy toward more consumption and services and away from investment and infrastructure led growth.

The demography impact. The Chinese population is graying rapidly, and the size of the working population is shrinking. This trend means labor cost pressures are likely to remain and rising prices in service sectors will prevail. Labor intensive and low-value-added activities  will continue to shift to cheaper locations either within or outside  China. Another key trend is the migration into towns and cities. China's urban population is expected to reach 1 billion in 2030, which will provide some buffer against the shrinking working-age pool as new workers move from rural subsistence farming into the secondary and tertiary sectors.

The political dimension. More so than in any other market, the business climate in China is shaped by government policy and regulatory developments, and sometimes the lack thereof. The 3rd plenum in late 2013 set the stage for China’s reform direction under Xi Jingping over the next 10 years.

The government announced some major paradigm shifts, which in recent years have been given more color: from quantity to quality, accepting a lower level of growth (the new normal) and a focus on the environment. The role of the government was also to change: from participating in and planning the economy to stepping back. The economy is too big and complex, and the government cannot control all aspects of it in the planned manner of the past. The stock market turmoil over the past six months has made this very clear, but it remains to be seen if China truly liberalizes key aspects of the economy.

Other themes embraced by the government include more focus on R&D and innovation; a stronger system to check corruption (we’ve certainly seen plenty of that!); encouraging foreign investment in coastal cities; and state-owned enterprises (SOE) reform, allowing private investors to take a stake and controlling interest in SOEs.

 SOE Reforms for Level Playing Field?  In practice, the SOE reforms so far seem to have taken mostly the direction of merging players into monolithic giants. The challenge with the SOE reforms is that State-owned Assets Supervision and Administration Commission of the State Council (SASAC) doesn’t really own these businesses; they are overseeing them on behalf of the state council. SASAC doesn’t appoint the senior management nor does it seem to have any operational control. So it has really been more about reducing the number of SOEs through mergers and trying to make them bigger in an attempt to create global champions. But what is needed is to open up these SOEs to more competition to drive innovation and operational excellence. But that is not really SASAC’s role – that is more National Development and Reform Commission (NDRC) territory.

Besides the government’s ongoing efforts in shifting from quantity to quality, fast growth to environmental awareness, and from planning the economy to assisting it, China last year proposed several industrial upgrade initiatives, including Made in China 2025 and Industry 4.0, aimed to boost high technology and innovation over the long term.

Made in China 2025…  The Made in China 2025 program starts to provide a level of specificity that gives more concrete direction as to where China is heading and how company leaders should align their strategies. It’s interesting that the program focuses on a 10-year horizon rather than the more typical five-year period. China’s ambition is to become a manufacturing power that leads through innovation and not through scale or costs. There is no long-term value in the latter.

But this is not easy to achieve. China has learned it is difficult to plan for innovation and get results in the short term. Unlike building airports or power plants, innovation takes time and can be unpredictable, and true innovation does not adhere to fixed timelines. As a result, initial targets for some major programs and complex technological projects were not being met (e.g., the C919 aircraft program and China’s aggressive push into new energy vehicles in the 12th FYP).

So a 10-year horizon was taken, and already it has been announced that this plan will be followed by three more plans, taking us to 2049, the centenary of the founding of the People’s Republic. By that time, China needs to be a leading manufacturing power, on par with global leaders in Germany, Japan and the U.S.

Made in China 2025 specifies the key tasks necessary to achieve China’s ambitions. These include improving manufacturing innovation, integrating technology and industry, strengthening the industrial base, fostering Chinese brands, enforcing green manufacturing, promoting breakthroughs in 10 key sectors, advancing restructuring of the manufacturing sector, promoting service-oriented manufacturing and manufacturing-related service industries, and internationalizing manufacturing.

The plan also identifies the 10 key industries that will likely enjoy high-growth prospects within China’s multispeed economy: new information technology, numerical control tools and robotics, aerospace equipment, ocean engineering equipment and high-tech ships, railway equipment, energy-saving and new-energy vehicles, power equipment, new materials, medicine and medical devices, and agricultural machinery.

… or Made in India?  The key theme that cuts across the plan is innovation: China needs to upgrade manufacturing from quantity to quality. There is recognition that China needs to follow this path as it is at risk of getting stuck in the middle. China is not able to compete with advanced nations such as the U.S., Germany and Japan in terms of advanced manufacturing and innovation. At the same time, emerging economies with their own advantages are catching up and could potentially pose a threat from the bottom: Prime Minister Modi of India last year introduced the concept of “Made in India” making clear that China cannot take it status as manufacturing hub of the world for granted.

 So What Does It All Mean?

If you are running an industrial or business service company in China, what’s next? What does it all mean for us laymen trying to run a business? We are paid to grow a business in a sustainable and profitable way in order to keep the shareholders happy. So what are the concrete opportunities for businesses in China?

Overall, we think the outlook is quite positive if you can bear some of the short-term wobbles:

• The size of the economy will double in the next 10 years
• A drive towards innovation and globalization means a more level playing field
• Innovation, quality and manufacturing excellence become key competitive levers – pure cost-driven competition or government relationship models are less likely to succeed
• Market forces will play a more prominent role as opposed to heavy control by the government

But the easy days are over. Companies have to pick their battles carefully and develop strategies and capabilities to have lasting success. We have selected three investment themes that align against the major macro trends and that can support continued development of industrial product and service providers in China.

Automation and robotics. With labor costs going up, many Chinese manufacturing businesses are now experimenting with introducing automation and robotics in their production processes in an effort to save costs and improve productivity. Also, liability is an increasing expense for hazardous industries, and robotics can help reduce worker exposure. Many car part companies are actively looking at robotics to help in tasks such as assembly of airbags, epoxy application and ultrasonic welding of plastic parts. Companies in the automation and robotics sector can gain a competitive advantage by supporting clients as they adjust their manufacturing processes and adopt best practice.

Green energy and new materials. Hydro energy is China’s main renewable energy source but is capped by the lack of suitable new locations, and the government has recently halted construction of several dams in Sichuan province citing environmental concerns. So growth will need to come from other areas, especially after the recent commitments from China at the U.N. Climate Change Conference in Paris.

Wind and solar power will continue to be pillars in the new-energy era of the next two decades. But a wide variety of other innovative technologies, including heat transfer and thermal energy storage media, will be required to enhance energy efficiency and open opportunities for companies. The government is also looking at more established technologies (such as natural gas) to take a major role in China's efforts to clean up the air and cap carbon emissions.

Business model evolution — from product to solutions. Driven by rising labor costs and more demanding customer needs, we are seeing a gradual shift away from competing purely on cost in the industrial product and service space. Customers are increasingly looking at value, and suppliers are increasingly looking at lowering total cost of ownership (TCO) — reducing downtime, optimizing maintenance and repair, and improving product life time. They are also increasingly looking not just for pure products but for solutions that integrate financing, training, after-sales service and product development. Against this backdrop, companies will need to offer more application-specific products that help customers lower TCO/manufacturing costs, enhance their products, and reduce environmental impact. 

No doubt many others opportunities exist — each will need to be carefully weighed against China’s macro trends and the company’s resources and capabilities.  By developing a sound understanding of how the major macro trends are impacting market demand, customer needs and competitive dynamics, business leaders can identify which products or services are going to be in greatest demand and can align their capabilities and resources to compete effectively in China’s multispeed economy.

Click here for a link to the article in Eurobiz China.

Michel Brekelmans is a Partner at L.E.K. Consulting and Managing Director and co-head of L.E.K.’s China practice. He has 20 years of experience in strategy consulting and has been based in Shanghai since 2006. L.E.K is a global consulting firm that supports business leaders in evaluating investments and developing strategies and organizational capabilities to deliver significant impact on the performance of their business.   L.E.K. helps investors and executives across three major areas:

• Strategy formulation and activation
• Organisational and operational development
• M&A Services

L.E.K has been operating in China since 1998 through offices in Shanghai and Beijing. 

www.lek.com